Quora Answer: Do Mutual Funds Face Liquidity Issues if Everyone Wants to Disinvest Simultaneously?

The following is my answer to a Quora question: “Do mutual funds face liquidity issues if everyone wants to disinvest simultaneously?”

What you are referring to, here, is liquidity risk within mutual funds.  It does not have to be every single investor divesting for a mutual fund to have liquidity issues.  Depending on the circumstances, it might not even take one.  In such an extreme case, a fund may apply for a freeze on redemptions before liquidating.

Mutual funds need either a cash float, or some readily convertible security, to process the redemption requests of investors that buy into the fund.  This is normally a non-issue since they always keep some of that ready for the normal course of business.  This is especially so, if the fund has a ready secondary market, and there is a lot of trade in it.  On the other hand, there are funds that hold risky positions, or have low trading volume.  Either position affects liquidity because the fund’s ability to raise cash at a minimal cost is affected.  The riskier it is, the more expensive it is to raise that cash.

Depending on where the fund is based, there is legislation stating a maximum period, in terms of days, that a fund can withhold cash before distribution to shareholders.  These acts of legislation also limits the amount of assets that may be kept in illiquid securities to prevent this liquidity crunch.  As a practice, funds keep some form of cash position, including money market.  This cash is used to fund daily transactions.  A fund that neglects this should be avoided.

We have to keep an eye on the fund movement in terms of transactions.  Redemptions should be offset by funds coming in.  This means the fund is healthy, its assets have a secondary market, and there is confidence in the management.  In a crisis, funds with undesirable assets, such as junk bonds, or assets in the wrong place, with inclement political exposure lose that liquidity because no new funds come in, and investors are seeking to redeem whatever position they already have.  A healthy mature fund should have bond holdings that steadily mature, contributing to income and liquidity.  Much of that income should be reinvested, not taken out, of the net asset pool.